Think cheap: It's worth shopping around for lowest mutual fund fees

Gail Marksjarvis

Despite some rallies, the stock market has not been on your side in recent weeks.

If you are like many mutual fund investors, it probably has been zapping your savings since early May. Riskier funds like small caps and emerging-market international funds have been clobbered the most. More sedate international and U.S. funds have gone down less than edgier ones. But virtually nothing has been spared.

Analysts aren't providing a lot of encouragement about the near future, either. There is fear in the market, as investors worry that the Federal Reserve and its counterparts abroad might slow the economy too much. That, of course, could crimp corporate profits and consequently cause stocks and mutual funds to lose value.

So what do you do?

Try being a cheapskate.

The stock market is out of your hands, but you do have more control than you might think about how much money your investments will earn ... or lose. That is, you can make sure you aren't paying too much for the privilege of investing money in mutual funds.

You might not realize you pay fees for your mutual funds. But they are there, whittling away the money you would have made if you were paying less.

Say you have $10,000 invested in a mutual fund, and the expenses you pay are 0.93 percent of your assets. That's $93, and doesn't sound like a drastic sacrifice in a single year. But look at the impact after 35 years. Say during that time, you average a 10 percent return on your money, in line with the historical returns of stocks.

At the end of the 35 years, you would have $202,637, after paying a total of $21,953 in expenses. If there had been no expenses, you would have earned about $281,000.

You would have earned about $78,300 more without the expenses, because the fees you pay hold you back in two ways: You pay money to the fund company; then that leaves you with fewer assets, so the power of compounding--or earning interest on interest--is limited.

Of course, no mutual fund charges nothing. But you can cut the impact of expenses down substantially. If, for example, you put the $10,000 into a Vanguard 500 Index fund, you would pay only 0.18 percent of your assets in expenses.

Over 35 years, that would be only $5,128 in expenses. Because more of your money would have been working for you--instead of going to the fund company--you would end up with about $263,800, assuming a 10 percent average annual return.

To check your own expenses, just look for one number: the expense ratio. You can find it in the prospectus, or booklet, you received when you invested in your mutual fund, or you can call your fund's toll-free number and ask for it. If you have a broker, he or she should also be able to give you the number.

To calculate the impact of your expenses, try the "fund expense" calculator used for the above examples: www.dinkytown.net/java/FundExpense.html.

If you are paying more than 0.93 percent for your funds, you probably are paying more than necessary. Several major mutual fund companies lately have reduced their fees, said Morningstar mutual fund research director Russel Kinnel.

Some have cut them under pressure from regulators--a result of mutual fund scandal investigations over market timing and late trading in 2004.

Increasingly, however, the fund industry is cutting fees because fund companies have a formidable new competitor--exchange-traded funds, or ETFs. Many ETFs are similar to index mutual funds, but trade like a stock, and often charge very low fees--just 0.10 percent of assets annually in some cases.

Because they track indexes, they get by without paying for stock-picking talent. An index fund--whether an ETF or a traditional mutual fund--simply mimics a slice of the stock market, rather than trying to find winning stocks.

For example, the Vanguard 500 Index keeps expenses at 0.18 percent because it simply copies the Standard & Poor's 500, an index of 500 large companies such as General Electric, Microsoft and Exxon Mobil.

The typical investor with a mutual fund handled by a professional stock-picker, however, pays significantly more. Kinnel notes that after recent changes, investors are paying an average of 0.93 percent of their assets in U.S. stock funds.

Picking stocks in foreign countries is considered more expensive, and the typical investor in international stock funds is paying 1.10 percent, Kinnel said.

If you have a broker, the chances are that you are paying even more than average 0.93 percent, and those expenses are probably eating away at your future returns.

Kinnel said funds sold by brokers tend to have higher fees, with some approaching 2 percent. In addition, brokers usually charge a "load," or sales charge--another drain on your returns.

Among the load shops, the cheapest--and consequently most attractive--is American Funds, with an average cost on its funds of just 0.76 percent, Kinnel said. The next most reasonable are Franklin, averaging 0.98 percent, and Van Kampen, at 1.15 percent.

Among the firms that have cut fees the most are Fidelity (with average expenses at 0.75 percent in its funds) Vanguard (0.22 percent), Dodge & Cox (0.53 percent), T. Rowe Price (0.80 percent) and Janus Funds (0.87 percent), according to Kinnel.

While those that have cut fees tend to be very large firms, Kinnel notes that some small fund firms--such as ICAP funds and Schneider Funds--already charged low fees.

Meanwhile, only five of the largest 20 fund companies have lowered fees. And some firms have raised them. Among those with increases: Franklin, Columbia and Putnam.

"There is no reason to settle for a high-cost fund," Kinnel said.

While investors might think a more expensive fund will provide better performance, the opposite tends to be true.

Because fees eat away at returns, more-expensive funds generally perform worse than cheaper ones, according to Morningstar research. In addition, firms trying to compensate for the extra charges often take more risks.

If you have a bond fund, fees are also important--in fact, possibly more so than for stock funds. That's because bonds tend to provide smaller returns than stocks. Over the last 80 years, government bonds have averaged a 5.5 percent return, compared to 10.4 percent for stocks, according to Ibbotson Associates. So giving up 0.93 percent in expenses is particularly costly in bonds.

Investors also need to safeguard against excessive fees in target date mutual funds, or life-cycle funds--one-stop shopping funds that are increasingly showing up in 401(k) plans.

The funds are attractive because they invest in a variety of stocks and bonds, changing the mix as the investor approaches retirement, without investors having to think about making any choices. But the funds also sometimes stack expenses upon expenses, eroding their value, said Morningstar analyst Greg Carlson.

Among those with high fees are the State Farm LifePath funds, he said. He suggests investors keep fees on target-date funds below 1 percent.